Should BOG hold more gold as FX reserves?

In recent months several international commentators have called for central banks in emerging market economies to hold a higher percentage of gold as part of foreign exchange (FX) reserves. Large emerging market economies such as China and India hold less than 7% of foreign reserves as gold. However, the legacy of the Bretton Woods system means the Federal Reserve holds about 75% of its foreign reserves as gold, Italy about 65% and France around 70%. It should be noted that the United States does not need to hold a lot FX reserves given that the US$ is the world’s dominant reserve and vehicle currency, and it will be that way for a few more decades until viable alternatives share the space, but will not be able displace the dollar (far left-wing PPP ideologues should bear this in mind).

Gold is a very liquid asset that serves the purpose of making international payments (like US Treasury assets). So, for example, if a small economy like Guyana needs to buy an aircraft, the manufacturer will not take payments in gold bars but will accept the US$ the small economy’s gold bars can purchase on the very liquid global market.

Meanwhile, the audit of the Guyana Gold Board (GGB) revealed several important findings such as possible fraud at the previous Bartica office (it seems like they were deliberately buying gold at a high price, hence a possible rip off of the people’s money) and the G$10 billion trading loss. As a result, some news reports and commentators have suggested that Bank of Guyana should be more involved in buying gold from local miners. It should be noted – as reported by IMF statistics – that BOG and numerous central banks of small emerging economies already hold part of their FX reserves as gold. I would therefore outline some of the factors to consider if the BOG is to significantly increase its share of FX reserves in the form of gold.

The first thing to note is gold purchases from local miners will expand the money supply and account for the build-up of excess reserves in the banking system, regardless of whether the BOG or GGB purchases. In the case of the GGB, its purchases are financed from the Ministry of Finance or from an overdraft at the central bank. If the central bank increases its purchase it will also expand the money supply by crediting the bank accounts of the local miners, thus injecting liquidity into the banking system.

The excess reserves are in Guyana dollars and should not be confused with the FX reserves of BOG. Nevertheless, the two are obviously related and it is this fact that makes exchange rate management complex. Once commercial banks have excess reserves paying zero interest rate they now have to engage in a portfolio management decision. Should they hold on to the zero-interest excess reserves, buy foreign exchange assets, buy an interest-earning liquid asset (domestic Treasury bills) or expand credit to domestic consumers and investors? My academic research has found virtually no evidence that non-remunerated excess reserves result in an expansion of domestic loans. On the other hand, these excess reserves in Guyana dollar will more likely be converted into foreign exchange assets, thus complicating the central bank’s task of exchange rate management (Guyana’s nominal anchor). It is for this reason Treasury bills have to be sold as a compensating system for the foreign assets and possible loss of foreign currencies; hence the accumulation of excess liquid assets in the banking system.

The selling loss of G$10 billion incurred by GGB involves failing to manage the sales of gold in the spot market. As everyone knows, to make a commercial profit one needs to buy low and sell high. The Bartica office was allegedly buying high as a form oligarchic expropriation of the people’s money. The managers at central GGB found themselves selling low in the spot market. The loss in the spot market could have been prevented by buying put options. These options will obviously have a price or premium, but it’s the kind of management in which the GGB should be involved so as to safeguard from losses, assuming of course there is not a political motive to make a loss in the first place to transfer the people’s money to a chosen few. Unfortunately almost everyone in Guyana seems to have a political motive and sound economic management is an afterthought.

If the BOG should be more involved in gold purchases the risk will be shifted unto its balance sheet, which is not a good situation as this institution needs to creditably signal stability. The BOG is focused on exchange rate

management and financial stability. If the added gold on the asset side of the BOG’s balance adds greater volatility – as it will – the Bank loses the credibility it needs to signal it is serious about macroeconomic and financial stability. It is easy to show that as the percentage of gold rises in the Bank’s portfolio the chance of a capital loss increases.

The reason for this situation is the wide swings in the spot price of gold in the world market. Buying out options is of limited use as these options will not have the central bank’s long-run time horizon, but is more likely to be consistent with that of the GGB. The central bank is in it for the long term while GGB has to unload the gold fairly quickly to make a profit; therefore, it would be cheaper for the latter to hedge than BOG as the equation setting the premium suggests.

The return on gold includes the leasing rate plus price appreciation. Of course, the price doesn’t always appreciate, hence the inherent risk. There is an active global leasing market for gold. Manufacturers, gold miners and jewellers often lease gold as the leasing rate is often lower than LIBOR or bank financing. A jeweller, for instance, can rent some gold, make jewels, sell jewels and then return the gold plus a small amount to reflect the leasing rate. The big central banks around the world often participate in the leasing market. The relevant Guyanese authorities might want to explore this strategy in more detail. My hunch is the leasing rate of return will not compensate for the volatility associated with increasing the portfolio beyond 30% gold. There might very well be a lower threshold.

In spite of the problems associated with GGB, I still believe there is a role for a central agency buying gold from miners and selling them for a profit, even a slim one. The problem is not GGB but the fact that no one from the previous government is going to jail. If the task of selling gold internationally is decentralized chances are those small and medium scale miners will not bring back a large percentage of the foreign exchange to Guyana. The same principle relates to GuySuCo as the policy makers ponder, with much dissonance, what to do with this state-owned corporation. A decentralized FX market in Guyana means it will become much harder for the BOG to target the exchange rate, and as a result one can expect greater macroeconomic instability and poverty with its associated social ills.